Realigning investment tax incentives to job opportunities

The recent decline in global commodity prices is proving to be very costly for South Africa. The deterioration of South Africa’s terms of trade since 2012 cost at least four percentage points of gross domestic product (GDP) growth. This estimate does not account for some important indirect effects generated by the commodity price shock, including the heightened volatility of the rand and its impact on investment decisions. Instead of global monetary policy developments, commodity price volatility is now understood as being the main driver of exchange rate and capital account volatility in South Africa, and in emerging markets more generally. And 91% of European investors surveyed in the second half of 2014 identified the volatility of the rand as a major constraint to doing business in South Africa.

South Africa has long acknowledged the need to reduce its dependency on minerals. The National Industrial Policy Framework, which has been in place since 2007, retains as its first objective “diversification beyond our current reliance on traditional commodities” (minerals in particular). But it nonetheless remains unclear whether the country’s policies, especially tax policies, are consistently geared toward this objective.

In the ninth volume of the South Africa Economic Update, we compute the net impact of the various tax policies currently in place on rates of return to investment, the so-called marginal effective tax rate (METR). In a nutshell, the METR measures the difference in rates of return to investment before and after taxes are paid by firms. The larger is the METR, the lower is the economic incentive to invest in a given sector. The results are unambiguous: the mining sector enjoys a huge tax advantage vis-a-vis other sectors. Our computations indicate that to generate a post-tax rate of return of 10%, an investor would need to invest in a mining project that would generate a pre-tax rate of return of 8.8%; by contrast, in a manufacturing project, a pre-tax rate of return of 29.6% would have to be achieved. This marked difference highlights the extent to which tax incentives impact profitability and, in turn, incentives to invest. At the core of these differences lie different corporate income tax rates across sectors, and the possibility for the mining sector to depreciate 100% of its investment within a year.

Such a significant tax advantage may explain to a large extent the misallocation of capital recorded since 2012. Through a composition effect, total factor productivity declined by 1 percentage point between 2012 and 2015, as capital increasingly concentrated into less productive sectors and away from the manufacturing sector. For similar capital endowments, South Africa generated 1% less value added in 2015 than in 2012.

Other factors, including power outages, fractious labor relations, lack of competition, and delayed response from investors to changing terms of trade, may have also contributed to the misallocation of capital. But as electricity capacity and labor relations have been improving—thanks to the efforts of the government and unions—there is today a strong policy case to review the investment tax incentives framework. At a minimum, such a framework should not discriminate against the manufacturing sectors, the more so as their price competitiveness and related development potential are increasing with the depreciation of the rand.

Such a realignment of tax incentives across sectors and with respect to emerging comparative advantages would stimulate not only growth, but also job creation, given the very large employment multipliers in the manufacturing sector, especially in urban agglomerations. One job directly created in the manufacturing sector indirectly generates another 3.8 jobs in South Africa, against only 1.1 in the mining sector. This realignment will obviously be insufficient to propel growth to the levels needed to eliminate poverty, given the lack of skills and spatial integration, which will require time and concerted efforts to overcome. Nonetheless, realigning tax incentives would contribute to the rebound of the South African economy, building on more stable, inclusive, and long-lasting growth drivers.